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Hi there,
I have doubt with regards to APV, when calculating the Tax shield for the interest payment why do we use the normal cost of debt as the discount factor rather than the subsidized cost of debt.
For Eg: In case of question Zhichi, for calculating the present value of the interest payable we have used the annuity of cost of debt of 6% (4.212 – 0.943) (which is the normal loan rate) – logically the tax saving should be discounted at the cost of debt being used for this project that is the subsidized interest rate which should be at 3% (4.580-.971).
Please clear my doubt so I can know the logic behind this
In future you must post questions in the Ask the Tutor Forum if you want me to answer. This forum is for students to help each other 🙂
As I do explain in my free lectures on this, the tax shield should be discounted at the interest rate applicable to the associated level of risk of the borrowing. The fact that the loan is subsidised does not make it any less risky which is why the normal loan rate is used.
(As the examiner states in his answer, it is also aways allowed in the exam to use the risk free rate instead on the assumption that it is risk free. This obviously gives a different final answer, but is always allowed as again I make clear in my free lectures.)Thank you so much for your response.
I am sorry for posting my question in wrong forum. I assumed both the forum and ask the tutor is same.
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